Chapter 5:
Risk and Rates of Return
Financial management
1. Some definitions
Investment Returns
The rate of return on an investment can be calculated as follows:
(Amount received – Amount invested)
Return = ________________________
Amount invested
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1. Some definitions
Risk
The chance that some unfavorable events will occur
Investment Risk
The degree of uncertainty and/or potential financial loss inherent in
an investment decision
Two types of investment risk:
1. Stand-alone risk – the asset is considered by itself
2. Portfolio risk – the asset is held in a portfolio
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1. Some definitions
The Risk-Return Trade-Off
Investors like returns and they dislike risk.
→There is a fundamental trade-off between risk and return
→ The investors will take on more risk only if they are provided
with higher expected returns
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1. Some definitions
The slope of the risk-return line
depends on the individual investor’s
willingness to take on risk.
A steeper line indicates that the
investor is more risk-averse.
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1. Some definitions
The slope of the cost of capital line
depends on the willingness of the
average investor in the market to
take on risk.
A steeper line indicates that the
average investor is more risk-
averse.
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2. Stand-alone risk
The risk an investor would face if he or she held only one
asset
Statistical measures of Stand-alone risk
1. Probability distributions
2. Expected rates of return (“r hat”)
3. Historical, or past realized, rates of return (“r bar”)
4. Standard deviation (sigma)
5. Coefficient of variation (CV)
6. Sharpe ratio
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2. Stand-alone risk
Probability distributions - Listings of possible outcomes or
events with a probability (chance of occurrence) assigned to each
outcome
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2. Stand-alone risk
Probability Distributions
Martin Products U.S. Water
Economy Probability Rate of Return Probability Rate of Return
Strong 30% 80% 30% 15%
Normal 40% 10% 40% 10%
Weak 30% -60% 30% 5%
100% 100%
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2. Stand-alone risk
Expected rates of return - The rate of return expected to be
realized from an investment; the weighted average of the
probability distribution of possible results
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2. Stand-alone risk
Expected rates of return
Martin Products U.S. Water
Probability Probability
Economy Probability Rate of Return x Rate of Return Probability Rate of Return x Rate of Return
Strong 30% 80% 30% 15%
Normal 40% 10% 40% 10%
Weak 30% -60% 30% 5%
100% Expected return 100% Expected return
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2. Stand-alone risk
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2. Stand-alone risk
The tighter the probability distribution of expected future returns,
the smaller the risk of a given investment
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2. Stand-alone risk
Standard deviation - A statistical measure of the variability of a
set of observations; a measure of how far the actual return is
likely to deviate from the expected return
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2. Stand-alone risk
Squared
Probability Deviation x
Economy Probability Rate of Return x Rate of Return Deviation Deviation Square Probability
Strong 30% 80% 24%
Normal 40% 10% 4%
Weak 30% -60% -18%
100%Expected return 10% Variance
Standard Deviation
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2. Stand-alone risk
Historical data
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2. Stand-alone risk
Coefficient of Variation (CV) - The standardized measure
of the risk per unit of return; calculated as the standard
deviation divided by the expected return
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2. Stand-alone risk
Sharpe Ratio - A measure of stand-alone risk that compares the
asset’s realized excess return to its standard deviation over a
specified period.
Using historical or forward-looking estimates of expected returns
Investments with higher Sharpe ratios performed better, because
they generated higher excess returns per unit of risk
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3. Portfolio Risk
What is important is the return on the portfolio and the
portfolio’s risk => The risk and return of an individual stock
should be analyzed in terms of how the security affects the
risk and return of the portfolio in which it is held
The risk of a stock held in a portfolio is typically lower than
the stock’s risk when it is held alone
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3. Portfolio Risk
Expected Portfolio Returns - The weighted average of
expected returns on the stocks in the portfolio
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3. Portfolio Risk
Percent of Expected Return x
Stock Expected Return Dollars Invested Total Percent of Total
Microsoft 7,75% 25.000 25%
IBM 7,25% 25.000 25%
GE 8,75% 25.000 25%
Exxon
Mobil 7,75% 25.000 25%
7,88% 100.000 100%
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3. Portfolio Risk
If adding another stock with a higher expected return, the
portfolio’s expected return would increase, and vice versa
Portfolio risk normally declines as the number of stocks in a
portfolio increases. Why?
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3. Diversification
Consider the data and graph of stocks W and M individually and
of portfolio with 50% in each stock
The two stocks would be quite risky if held in isolation but when they
23 are combined to form Portfolio
FacultyWM, they
of Finance have no risk
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3. Diversification
Correlation coefficient
The tendency of two variables to move together is called
correlation, and the correlation coefficient (ρ) measures
this tendency.
▪ Perfectly negatively correlated: ρ = - 1
▪ Perfectly positively correlated: ρ = 1
▪ Not related (independent): ρ = 0
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3. Diversification
Two perfectly negatively correlated stocks (ρ = -1)
Stock W Stock M Portfolio WM
25 25 25
15 15 15
0
0 0
-10 -10 -10
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3. Diversification
Two perfectly positively correlated stocks (ρ = 1)
Stock M Stock M’ Portfolio MM’
25 25 25
15 15 15
0 0 0
-10 -10 -10
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3. Diversification
Could we completely eliminate risk? => NO
The portfolio’s risk declines as stocks are added, but at a
decreasing rate
The portfolio’s total risk can be divided into two parts, diversifiable
risk and market risk
Most stocks are positively (though not perfectly) correlated with the
market (ρ between 0 and 1) => On average, portfolio risk declines
as the number of stocks in a portfolio increases
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3. Diversification
sp (%)
Diversifiable Risk
35
Stand-Alone Risk, sp
20
Market Risk
0
10 20 30 40 2,000+
# Stocks in Portfolio
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4. Capital Asset Pricing Model
Breaking down sources of risk
Stand-alone risk = Market risk + Diversifiable risk
• Market risk – The risk that remains in a portfolio after
diversification. This risk is also known as nondiversifiable or
systematic or beta risk.
• Diversifiable risk (company-specific, or unsystematic risk) -
That part of a security’s risk associated with random events;
can be eliminated by proper diversification
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4. Capital Asset Pricing Model
The standard deviation of expected returns is not appropriate to
measure a stock’s risk because it includes risk that can be
eliminated by diversification. How should we measure a stock’s
risk in a world where most people hold portfolios?
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4. Capital Asset Pricing Model
CAPM - A model based on the proposition that any stock’s required rate
of return is equal to the risk-free rate of return plus a risk premium that
reflects only the risk remaining after diversification
Use CAPM’s intuition to explain how risk should be considered when
stocks are held in portfolios
Under the CAPM theory, beta is the most appropriate measure of a
stock’s relevant risk - The risk that remains once a stock is in a
diversified portfolio, is its contribution to the portfolio’s market risk
Video
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4. Capital Asset Pricing Model
The beta coefficient
The tendency of a stock to move with the market is measured by
its beta coefficient, b
Beta: a metric that shows the extent to which a given stock’s
returns move up and down with the stock market
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4. Capital Asset Pricing Model
The beta coefficient
Beta measures market risk, indicates how risky a stock is if it is
held in a well-diversified portfolio
If beta = 1, the security is just as risky as the average stock
If beta > 1, the security is riskier than average
If beta < 1, the security is less risky than average
Most stocks have betas in the range of 0.5 to 1.5
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4. CAPM
The beta coefficient
The steeper the line,
the greater the stock’s
volatility and thus the
larger its loss in a
down market
The slopes of the lines
are the stocks’ beta
coefficients
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4. Capital Asset Pricing Model
Calculating beta - Without a crystal ball to predict the future,
analysts are forced to rely on historical data. A typical approach to
estimate beta is to use the security’s past returns against the past
returns of the market
Rise-over-Run – divide the vertical axis change that results from
a given change on horizontal axis
Financial calculator
Excel – SLOPE function
Regression – slope of the regression line
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4. Capital Asset Pricing Model
Beta of a portfolio - a weighted average of its individual
securities’ betas
Adding a low-beta stock would therefore reduce the
portfolio’s riskiness and vice versa
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4. Capital Asset Pricing Model
The relationship between Risk and Rates of return
For a given level of risk as measured by beta, what rate of
return is required to compensate investors for bearing that
risk?
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4. Capital Asset Pricing Model
The relationship between Risk and Rates of return
Market risk premium, RPM: the additional return
over the risk-free rate needed to compensate investors for
assuming an average amount of risk
RPM = rM – rRF
Note: estimates would be misleading if investors’ attitudes toward
risk changed considerably over time
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4. Capital Asset Pricing Model
The Security Market Line Equation (SML) - An equation that
shows relationship between risk as measured by beta and
required rates of return on individual securities
ri = rRF + (rM – rRF) bi
ri = rRF + (RPM) bi
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4. Capital Asset Pricing Model
Assume Treasury bonds yield rRF = 6%, and an average stock
has a required rate of return rM = 11%. If beta for Stock L = 0.5,
what is the required return on Stock L?
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4. Capital Asset Pricing Model
Calculating portfolio required returns
➢ The required return of a portfolio is the weighted
average of each of the stock’s required returns
OR
➢ Using the portfolio’s beta, SML can be used to solve for
expected return
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4. CAPM
The SML
The SML shows
the required
returns for a
given level of
risk
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